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Dividend ETFs: Your Best Buy for Income?

Exchange-traded funds focusing on dividend stocks give you diversity, but there are many to choose from.

As big banks have pushed their deposit rates to near zero and other safe fixed-income investments have seen their income dwindle, investors have had to find alternatives to produce the investment income they need. Especially for retirees and others who live off their investments, getting enough cash flow is essential to meet living expenses.

All week long, the Fool has looked at different ways to get more income from your portfolio. In previous articles about mortgage REITs and master limited partnerships, you got to learn about some unusual investments with unique attributes that help them produce huge amounts of income, some of which came with additional benefits like favorable taxation. Today, though, let's turn our attention to some more mainstream investments that have nevertheless captured the attention of income-seeking investors everywhere: dividend ETFs.

Joining the ETF crazeExchange-traded funds have taken the investing world by storm. As an alternative to traditional mutual funds, ETFs have several advantages, including favorable tax attributes, relatively low costs, and ease of buying and selling throughout the trading day. As the number of ETFs in the market has soared far past the 1,000 mark, you can find ETFs covering nearly any niche of the market that you're interested in.

With the increased demand for income-producing investments, though, it's no surprise to see that dividend ETFs have become an especially popular category among investors. The biggest dividend ETFs, which include Vanguard Dividend Appreciation (NYSEMKT:VIG), iShares DJ Select Dividend (NYSEMKT:DVY), and SPDR S&P Dividend (NYSEMKT:SDY), all have between $9 billion and $15 billion in assets under management, vaulting them into the upper echelons of ETFs by size.

Know what you ownBefore you buy a dividend ETF, it's important to know what angle it takes toward buying stocks. Some ETFs try to bring you as much current income as possible by picking stocks that maximize current dividend yields. Others, such as the ETFs listed above, focus more on long-term payout growth, with current yield being only a secondary consideration in many cases. Still others look at fundamental factors like the total value of dividends a company pays as a determinant of how to allocate ETF assets across different stocks.

Moreover, you can buy dividend ETFs covering different cross-sections of the market. International dividend ETFs own foreign stocks with attractive dividend characteristics, while you can also buy sector-specific or sector-exclusive ETFs that either include or exclude stocks from certain industries.

In addition to knowing what an ETF owns now, it's also useful to understand the mechanics of how an ETF will change its holdings over time. Some dividend indexes that ETFs track end up changing their components fairly often, which can push overall costs higher. Others are more stable, allowing turnover levels to remain low and helping to keep costs down.

RisksOne danger from using dividend ETFs comes from the mechanics of how various dividend-stock indexes work. If the index that your ETF tracks doesn't let in new dividend-paying stocks until after a fairly long waiting period, then you may miss out on the benefits of owning those stocks at a particularly lucrative time.

One extreme example of this phenomenon comes from tech giants Apple (NASDAQ:AAPL) and Cisco Systems (NASDAQ:CSCO), both of which have initiated dividend payouts recently. For Apple, going from paying nothing to making distributions at about a $10 billion annual clip to shareholders via dividends puts it in the top three dividend payers in the U.S. market, yet because of long waiting periods for many dividend indexes, most dividend ETFs won't own Apple for years. The same goes for Cisco, which has quickly raised its dividend since starting a payout in 2011.

Despite those concerns, dividend ETFs provide a convenient way to get much-needed income into your portfolio without taking on undue risk. By knowing your needs and choosing an ETF accordingly, you can find a dividend ETF that should be able to help you achieve your financial goals.

What other investments can get you the income you need?Dividend ETFs are a key part of many investors' income portfolios, but they don't always have the oomph that some people seek from their investments. Tomorrow, we'll take a look at some individual stocks in the telecom industry as a more aggressive way to get income for those willing to take on specific company risk.

Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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